An analytical comparison of long and short term contracts

Abstract

In this paper, we describe an analytical model to determine contracting policies for a firm that purchases components from external suppliers. The model evaluates the tradeoff between the flexibility offered by short term contracts arid the fixed investments, improvement opportunities and price certainty associated with long term contracts. We show that long term contracts may not always be optimal, and discuss conditions under which short term contracts may be justified. During a recent survey of supply managers, we observed that managers often tend to participate in short term contracts, even though they claim to seek long term relationships with suppliers. Sensitivity analysis of our model provides some explanation for this observed inconsistency. We also discuss managerial implications of the analysis.

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